Central bankers of the world appear to be shifting their positions

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Markets are down again this morning. Most are content to blame it on crude, down about 2 percent earlier on an IEA report that says the world is very adequately supplied with oil, and that demand (particularly from India and China) will not be as strong as anticipated next year.

But I think there's a bigger problem: the central bankers of the world appear to be shifting their positions. Despite the choppy data, a majority of the FOMC appears to be leaning toward a rate hike in September, despite the fact that the fed funds futures are assigning only a 15 percent chance of this happening. It's bigger than that: you not only have the Fed's Dennis Lockhart and Eric Rosengren trying to argue there is a case for raising rates, you have the ECB standing pat on more QE, and don't be shocked if the Bank of Japan's Haruhiko Kuroda turns cautious on expanding QE when he speaks next Tuesday.

So we now have the next eight days—leading up to the Fed meeting—with much higher levels of volatility than you might expect. You can see this in the VIX curve, which has flattened significantly in the last few days. The cash VIX is roughly 17.0, whereas the October futures contract is 17.6, November 18.6. The cash VIX was only 12 on Thursday.

Marko Kolanovic, who runs Derivative and Equity Strategies at JP Morgan, recently estimated that monetary policy since 2009 has accounted for a gain of 21 percent in Low Volatility Equities (consumer staples, utilities, telecom), a 10 percent gain in government bond indexes, and a 7 percent increase in gold.

A 21 percent gain for a Low Volatility strategy is substantial but would certainly not account for all the gains. The Powershares Low Volatility ETF, a basket of low volatility stocks, is up 75 percent since its creation in mid-2011.

Still, it's a substantial part of the gain. If central banks start "normalizing" policy, Kolanovic believes those gains would gradually go away. For example, if the Fed took three years to "normalize" rates at an even tempo, he assumes the average yearly historical gain in equities (about 7 percent) could be erased each of those three years.

"So we now have the next eight days--leading up to the Fed meeting--with much higher levels of volatility than you might expect."

Kolanovic concludes by noting "it is normalization of monetary policy, rather than the current level of accomodative policy, that poses a systemic risk for the market."

Some trading strategies may be exacerbating the volatility. Risk parity funds take a long, leveraged position simultaneously in U.S. equities and Treasurys. This is a strategy made famous by Ray Dalio of Bridgewater, who is speaking at Tuesday's Delivering Alpha event.

The idea is to target levels of volatility rather than a direct return. This strategy works very well during periods of low volatility—you lever up and stay long. But when volatility spikes up these leveraged funds will need to sell assets to get back in line with their volatility target. This can lead to periods of forced selling.

There are also many volatility hedge funds that have been created in recent years, that essentially sell volatility. They've been making money for some time, but when volatility goes up they get hammered.

Bottom line: there's plenty of strategies that have been created in recent years that depend on low volatility for their success. The Fed, in a sense, has been a partner with them in keeping volatility low.

But if that changes, these strategies will need to make adjustments. And those adjustments could themselves beget volatility.

  • Bob Pisani

    A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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